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Munich Personal RePEc Archive

Microfoundations of macroeconomics.

Post-Keynesian contributions on the

theory of the firm

Rosaria Rita Canale

University of Naples Federico II

2003

Online athttp://mpra.ub.uni-muenchen.de/2713/

MPRA Paper No. 2713, posted 12. April 2007

http://mpra.ub.uni-muenchen.de/2713/http://mpra.ub.uni-muenchen.de/2713/http://mpra.ub.uni-muenchen.de/

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MICROFOUNDATIONS OF MACROECONOMICS.POST-KEYNESIAN CONTRIBUTIONS

ON THE THEORY OF THE FIRM

byRosaria Rita Canale*

1. Introduction

Looking through contributions about microeconomic theory, from classicsto modern theory, it is possible to identify various attitudes on the role thatfirms play in the market. To simplify the existing multiplicity of opinion, twodistinct positions can be recognized: 1) the first one considers the theory of thefirm, its choices about price and production as ruled by consumer sovereignty,assuming that it is the eagerness to buy that drives the market. The entrepre-neurs and consumers interests converge thanks to automatic mechanisms

leading to equilibrium. It is well-known that neoclassical economists can be as-cribed to this trend of study. 2) the second position, on the other hand, consid-ers the side of production as having a higher incidence in the identification ofmarket equilibrium, as firms are able to set prices and co-ordinate demand be-haviour. This turn-round in causality defines a market where the demand-supply relationship does not follow the rules of competitive-marginalist equi-librium, but alternative principles. The aim of this study is to analyse the con-

tribution of Post-Keynesian scholars about this theme in the belief that the fun-damental assumptions and conclusions they have drawn represent an alterna-tive to the traditional theory, and are worth being considered carefully.

However, in the identification of the theoretical foundations of Post-Keynesian microeconomics theory, one can run into the difficulty of reducingto few unification principles the content of very different contributions, whichoften stand out for their critical positions vis--vis orthodox theory rather thanfor setting up the parts of a single alternative paradigm

1.

Besides, Post-Keynesians have a strong taste for macroeconomics themes,rather than for microeconomics ones, since they believe that the macro aggre-gates determine the behaviour of small decision-making units. In fact, looking

* Universit di Napoli Federico II Dipartimento di Scienze Economiche e Socialicanale@unina.it

1The criticism of neoclassical theory of the firm goes back to Sraffas contribution. Then,

many scholars devoted themselves to the study of alternative theories on firm and industry stress-

ing either the characteristic of managerial ability (Berle and Means 1932), or the institutional role

of firms in the market (Galbraith 1963 and 1968), or the oligopolistic nature of the production ofgoods (Baran and Sweezy 1966; Rothchilds 1947).

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at this literature, one can find a lot of contributions on this subject: the most re-puted (Kalecki 1954, and, for an expansion of this, Asimakopulos 1975 andCowling 1982) explain the formation of prices and produced quantities as theresults of decision-making process of firms as a whole. These theories set

themselves out as theories of investment decisions, profit accumulation, and theconflicting nature of income distribution. This point of view, however, is sub-

mitted to the criticism of those who argue that Post-Keynesian theory does notpossess persuasive microeconomics bases and that, even though it can be main-

tained that in the process of aggregation the firms behave uniformly in influ-encing aggregate production and income distribution, it is always necessary todefine the rules that allow each unit to take its production choices.

Most recently, some scholars have committed themselves to define the

rules of such a decision-making process and to clarify the reasons why the in-terests between consumers and producers in the market do not converge. In sodoing, they have tried to provide a microeconomic foundation to the distribu-tive conflict identified at an aggregate level. These different contributions un-

derline various dimensions of the undertakers decision-making mechanism.However, I believe that they share some common elements, as they are charac-terized by a common global vision that brings about a persuasive alternative tothe theoretical system of neoclassical microeconomics.

The aim of the present study is that of presenting the key elements of the

Post-Keynesian global vision on the theory of the firm, and of explaining whyprice mechanisms prevail over quantity-determining mechanism.

The paper is articulated as follows: the second section contemplates theproduction function and the associated cost function in the belief that the as-sumptions of Post-Keynesians are the base of an alternative microeconomictheory. In the third section, then, I present the theory of price formation and ofthe shape of the supply curve. The fourth and final section draws some conclu-sions.

2. The foundation of microeconomics: production and cost func-

tions

The foundation of the Post-Keynesian microeconomic theory is providedby the shape of the production function.

As a matter of fact, Post-Keynesian economists believe that the law of de-creasing marginal returns cannot be accepted since the organization of the

modern production structure and the nature of technology cannot be describedby the substitutability of factors of production. In fact, they maintain that:

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1. it is impossible to draw a straightforward line between the contributionof capital and the contribution of work to production as, in the modern marketeconomies, these two factors do not have an autonomous life

2.

2. each capital incorporates a given technology and is conceived to be used

in a peculiar way3.

From thesesimplepropositions, which Post-Keynesians believe that can be

drawn from observed facts, derive important results for the production func-tion. In fact, once the above mentioned assumptions are accepted, it ensues

that:a. it is impossible to single out the respective marginal productivity of

every factor of production4;

b. it cannot hold that product per worker is higher when the plant ca-pacity is underused5.

In other words, one cannot use the production function to define the equi-librium level of employment and the requirements for firms profit maximiza-tion

6. Therefore, it remains an open question how the single firm chooses its

plant dimension and the relative volumes of employment and production.According to Post-Keynesian scholars, the firm equips itself with the capi-

tal amount, that, associated to a given number of workers, generates a productvalue that can satisfy the effectual demand and guarantee the programmedprofit margin. In other words, the production function is ex-ante at fixed coeffi-

cients7and the dimension of plants is decided by expected demand. Further-

2 Joan Robinson was the first to handle this problem, inaugurating the famous debate on

capital theory. See Robinson (1953), (1956), (1967) and (1971). For an exhaustive study of thissubject see Harcourt (1972).

3Cfr. Robinson and Eatwell (1973).

4In practice, it is not possibile to isolate the effects of labour productivity deriving from

capital accumulation from those coming from technical progress (or, to use the jargon ofeconomists, the movement along the production function from those of the function itself). All

that can be said is that the growth of productivity will be so much higher as technical change ac-tivated by the new investment grows. Cfr. Kaldor (1966).

5In the traditional view, substitution between various inputs is always possible, both in the

short and in the long run. In the short term, for instance, it always possible to increase produc-

tion, by having more labour working on the same machine, thus decreasing the capital/labourratio and, therefore, the marginal physical product of labour, Lavoie (1992), p. 119.

6 These features of the production function also exist in neoclassical theory, but they arelimited to a peculiar case of the general condition of perfect substitutability. Therefore, the de-

bate between these two schools of thought moves on to a different level, where the ability of thegeneral case to represent the facts is compared. The question is then: Is there enough substitut-ability in an economic system to confirm the results of neoclassical theory? See Lavoie (1992).

7Firms, in deciding the technique of production to adopt at a certain time, instead of being

confronted to a whole range of techniques among which to choose, can be constrained to a single

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more, since in the short term a reduction of demand might occur, to which it isnot possible to answer suddenly by modifying the dimension of plants, it is rea-sonable to think that machinery is on that occasion underused. As a conse-quence, returns are ex-post constant rather than marginally decreasing, since

the machinery produces a constant output per hour of work associated to it8.

Assuming for simplicity sake a broad range of possible uses of plants or,

which is equivalent, infinite divisibility of capital it is possible to define theproduction function in a continuous interval:

Y = N for every N < NmaxY = Ymaxfor every N > Nmax.

Figure 1 explains this statement.

Q

N0 NmaxFigure 1

best use technique, that is to say, the production function ex-ante may be a single point. Cfr.Harcourt and Kenyon (1976) and Eichner (1976).

8In our pattern the technique is such that, in all sectors, the output per worker remains con-

stant until the existing capacity is completely used. When exceeding the point of full use of pro-duction capacity, the output cannot grow. Cfr. Robinson and Eatwell (1973).

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The figure shows that, below maximum plant capacity it is always possibleto increase the output by increasing the number of workers occupied, but abovethe co-ordinates (Ymax, Nmax) this is no longer possible unless by varying thequantity of capital or changing the technique. The result is that above a certain

amount of employment the marginal productivity will be null and the produc-tion function will loose its economic significance.

From the assumptions related to production derives the particular shape of

the functions of average variable costs and of marginal costs, which, in Post-Keynesian analysis, do not follow the trends commonly reported in the mostwidespread handbooks

9. What has been stated above clearly shows that the av-

erage cost and marginal cost curves maintain an unchanged trend as the output

varies both in the short and in the long run. In fact, the variation of the ratio be-tween the price of capital and the price of labour does not alter the choice of thequantity of output produced in the short and in the long run (the isoquantcurves are angular) but only the height of the cost functions.

It is possible to chart what stated above. The average variable cost function to make description realistic can be assumed as decreasing until it achievesa certain degree of plant working efficiency; beyond this value it is constantuntil it reaches the capacity limit. Above this limit, the function will becomevery slanting, as a huge increase of costs is necessary to obtain a very small (if

not null) growth of the output.The marginal cost is similarly affected by the peculiar trend of total costs.

After an increasing length, it becomes constant and takes the same value of av-erage variable costs. When it goes over the maximum productive capacity itrises more than average variable costs. This is reported in figure 2, in which thedotted line describes marginal costs (Cma) and the solid line the average vari-able costs (CMv)

10.

According to these assumptions, there is not a single cost minimizationcondition ensuring the efficient use of resources, but a variety of optimumconditions, all identifiable in the horizontal part of the average and marginal

costs curves.The firms, therefore, could be in the position of underusing plants without

necessarily waiving the profit margin from each product unit.

9The only microeconomics handbook containing alternative view is Koutsoyiannis (1979).

For some reports see also Graziani (1985).10

This description can be found in Eichner and Kregel (1975), Eichner (1976), Koutsoyian-

nis (1979), Lavoie (1992), Arestis (1992).

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Cma, CMy

Y0Figure 2

CMyCma

Overcapacity does not stem from an inefficient workings condition of the

firm, but from the fact that the equipment is underused because of suddenlychanges in demand, which the entrepreneur is not able to control. Possible re-verse events like a sudden increase of consumers purchases can induce theentrepreneur at the moment of the initial decision to oversize the plant giv-ing rise to a steady condition of underutilization

11.

3. The mechanism of pricing and the industry supply curve

Post-Keynesian scholars suppose that the market is not characterized by astiff competition and that, for this, the firms are price-makers rather than price-takers. The firms do not consider the price as a given quantity determined bythe market; instead, they fix the sale value on their own initiative, by adding a

margin to prime costs. In this way, the price comes out from the so-called

mark-upformula

11This argument is put forward by most scholars engaged on this subject. Koutsoyiannis has

transferred it into an handbook arguing that firms establish the size of plants so to settle some-

where between the two thirds and the three quarters of their global capacity. Koutsoyiannis(1979), p. 118.

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p = CMv(1 + ),

where is the profit margin.

This mechanism of pricing does not allow to embrace the traditional theoryin the identification of prices and produced quantities. According to the ortho-dox approach, only the existence of non perfectly competitive markets with ahigh level of demand compared to the size of supply could be responsible forfirms extra profits. In any case, however, the maximization conditions are sat-isfied. Accordingly, the mark-up turns out to be a special case generated bymarket distortions, and the profit maximization condition that equalize revenue

and marginal cost

(1) Rma= Cma

is still satisfied.In fact, because of the relationship between marginal revenue and the elas-

ticity of demand curve (), it must be

(2) Rma= p(- 1)/

Taking account of (1) and (2) and of the assumption that marginal costs are

constant and equivalent to average variable costs it must be:

p(- 1)/= Cmv

that is, the price must be equivalent to

p = [(/- 1)] Cmv

The analogy with the mark-up formula is evident. In fact, it is possible toidentify a definite relationship between margin on costs and elasticity of de-mand:

(/- 1) = (1 + )

But, according to Post-Keynesian scholars this reasoning is weak from thebeginning, as the equality in the margin of costs and revenue cannot suggest tofirms the optimum quantity of production.

Pricing operation is dictated by the will to gain a margin of profit from eachproduct unit. The causal relationship between produced quantities and prices

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that can be found in orthodox theory is here inverted as the firms first establishthe margin on costs and only after the size of the equipment, so to produce thequantity of goods demanded by the market at the price they have fixed

12.

In other words given the above assumptions about the production func-

tion each firms marginal revenue is represented by a horizontal line (withinfinite elasticity) always lying above the average costs curve. Therefore, con-

sidering also the assumptions about the cost function, two circumstances mayoccur: a) if the margin is null, the firms marginal revenue curve converges

with the marginal cost function, and the optimum amount of quantity is inde-terminate; b) if the margin is positive the marginal revenue meets the marginalcost in correspondence with the maximum plant capacity. This confirms thatthe firms are equipped with that quantity of capital that allows them to satisfy

the market demand and to gain the programmed profit margin. In other words,the relationship of cause and effect goes from the price to the quantity and thesame solution could be attained with different profit margins and different plantsizes.

12These considerations are confirmed by the circumstance that modern markets are charac-

terized by an oligopolistic system in which each firm once the global quantity of industrygoods to put into the market has been fixed sells on the basis of an agreement with the leader,

without any possibility of changing it by itself. The price that will be charged by the megacorpfor its product during the current pricing period is determined by the industry as a whole actingthrough the price leader. Since the price charged by the industry as a whole during the currentpricing period will be constant, whatever the rate of capacity utilization, the average revenue and

the marginal revenue will also be constant. This gives the revenue curve the appearance of an

infinitely elastic demand curve. Eichner (1976), pp. 43-4. This could be true also for a price-leader firm,because a change in prices could be responsible for the loss of leadership.

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Cu, CM

v

0 Y

Figure 3

CMv(1+) = R

ma

Ymax

Cu

CMv

Profits area

Figure 3 describes what stated above. The marginal revenue line (Rma) lies

constantly above the variable average costs curve (CMv) (in the case not de-

scribed of= 0 it converges on it). The figure shows the firms profit decision

according to the assumptions above stated. The area included between thecurve obtained adding to variable average costs a constant margin, that repre-sents the above-described marginal revenue, and the unit costs curve (Cu)represents the profits area, which comes out to be maximized in correspon-dence with the productive level matching the maximum utilization of equip-ment (Ymax)

13.

This price mechanism suffers from a limit of uncertainty since the firm given the downward-sloping industry demand curve might decide to reduce

the size of the plant and add a very high margin on costs to obtain the highestpossible profit for each unit of product, or conversely it might cut the marginand increase the quantity of product14.

13This fact does not exclude that the firms decide not to utilize the full equipment capacity.

In this case, as a matter of fact, they add to the goal of gaining a profit also a will to face a possi-ble rise of demand. The conditions for price setting do not change, of course.

14The crucial question then becomes: how do firms decide on the value of the margin of

profit over direct cost or unit cost?, Lavoie (1992), p. 137.

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Conceivable answers to this question are different and all seize some fea-tures of the pricing process. They underline different aspects of the equilibriumof the firm and offer altogether a persuasive answer to this question.

The prevailing solution considers the profit margin as tied to the goal to

achieve a rate of growth of the firms activity in the long term15

, or better, tiedto the need to raise money on the market for refinancing the firm in the follow-

ing periods. The latter operation could represent an alternative to bank financ-ing when the rate of interest is too high to be sustained16.

Moreover, the mark-up would be a historically determined value dependingon the extent of he conflict over distribution and on the relationships of produc-tion in the market under examination

17.

Further than that, there are in the opinion of Post-Keynesian scholars

objective limits to the growth of prices, which amount to:a) a will to make entry barriers strong enough to restrict competition

(if, for example, the price were too high, other firms could simplyrun into the sector, sell at a cheaper price, and subtract part of the

market to existing firms; therefore, the higher is the degree of mo-nopoly, the higher is the mark-up that firms may add, avoiding thecoming of other firms into the market18;

b) b) public intervention, which, in case of exorbitant prices, acts in or-der to make goods more accessible to the public.

In other words, the profit is an extra profit because it represents a goal a-priori established by the firm. A larger competition can cut the mark-up and

make the price equivalent to unit costs, although it is very unlikely that this cir-cumstance may occur, as the selling value is set on the basis of the size of thesectors entry barriers.

Therefore, perfect competition reduces to be a peculiar case in the generalconditions of the market functioning, and in no case, given the above assump-tions about the production function, the rules of marginalist distribution can beapplied to it.

From the assumptions described until now, it is possible to draw some con-

clusions about the form taken by the product supply curve of the whole indus-trial sector. He latter is described (see figure 4) by the curve of average variable

costs raised with a mark-up. This curve is horizontal until it reaches the maxi-15

The best known models stating this theory are Eichner (1976), and Harcourt and Kenyon(1976).

16See Eichner (1980). This formulation represents the microeconomic basis of the determi-

nation of mark-upat a macroeconomic level elaborated by Weintraub (1973).17

Robinson (1942) and (1977). But the argument was accepted by Kaldor. See Kaldor

(1985).18

See Kalecki (1938).

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mum plant capacity, becoming very steep beyond this value consistently withthe assumption that a higher degree of plant utilization cannot be attained orthat the production does not increase significantly, although it rises costs in aremarkable proportion.

p

0 Y

S

q0

D1D0

D2

Figure 4

p = Cmv

(1+)

Therefore, for each q < q0the price is p = CMv(1+), while for each q q0the price comes out to be higher and is determined by the height of the demandcurve. Thus, if undertakers correctly estimate (D0) or overestimate demand (D1)with regard to its actual value, they can always achieve the programmed profitmargin, even if, in the second case the profit amount will be lower. If they un-derestimate it (D2) with regard to its actual value, the consumer pressure coulddrive price up allowing the achievement of higher margins. In the long term,

then, the plant will be sized in such a way that it can exactly satisfy expecteddemand.

4. Some conclusions

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The observed features of Post-Keynesian microeconomic theory can bebrought to a single common matrix, that is the effort to provide an alternativepattern to orthodox theory.

The different elements of the pattern identified in the previous pages have

in common the refusal of the conditions posited by neoclassical theory, accord-ing to which the market, once the flexibility of monetary values is assured, is

able to render the interests of producers and consumers compatible.The alternative assumptions formulated by Post-Keynesian theory describe

a market where prices, set by the undertaker, coordinate the demand behaviour.From this derives that the firms have the power to fix the price, influencing inthat way the distribution of national income.

Two considerations arise from this analysis. First, it is no more possible to

think, as the orthodox theory does, that the equilibrium of the firm can be asso-ciated with conditions of maximum satisfaction of traders. Even though thecompetition between firms is stiffer, it is likely that the mark-up will be re-duced or cancelled. But since also in case of pure competition the income can-

not be distributed according to the principles of marginal productivity sincefollowing the assumptions made on the production function, the marginalproduct of labour equals the average product and Eulers theorem no longerapplies it is necessary to derive alternative distribution rules. Post-Keynesianscholars conclude that the total output value is distributed according to the

market power of parties.Second, the potential points of equilibrium are many. In fact, it is possible

that, in correspondence with a given value of monetary demand expected bythe undertaker, different prices and quantities depending on the dimension ofthe programmed mark-up and on the plant size

19.

All of this can be summed up in the statement that the economic systemdoes not tend by natureto an ideal state of equilibrium, because operators arenot all on the same level. The equilibrium position achieving a Post-Keynesianmodel arises from the market power owned by each part and from the capacitythe market has to mitigate conflicts.

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